Sometimes externality problems can’t be solved by private bargaining (transaction costs are too big). Public policy toward externalities. “Command-and-control” policies. Regulate behavior directly. Examples: Total ban on certain products or procedures. Require certain practices or standards. Set limits on emissions on individual basis.

“Market-based” policies. Provide correct incentives, then let private decision- makers make their own choices. Examples: Pollution taxes (“Pigovian taxes” -- Arthur Pigou) Designed to “internalize” pollution’s negative externality, forcing polluters to take account of impact on bystanders. Tradable pollution permits.

Sulfur dioxide (SO 2 ) and “acid rain.” ( “Acid rain”: A general term describing several ways that acids fall out of the atmosphere. Effects: Damage to forests, soils, fish, wildlife, materials, and human health. Causes: Mainly SO 2 (nitrogen oxides too). About 65% of SO 2 emissions come from electric power plants burning fossil fuels.

A power utility currently emits 10,000 tons/yr. SO 2. Suppose it is forced to reduce (“abate”) its emissions. Abatement methods: Install “scrubbers” to remove some SO 2. Switch to coal with lower sulfur content. Modify plant technology to burn natural gas. Different methods have different costs, so low-cost methods will be used first leaving high-cost methods as last resort.

Bottom line: “Marginal abatement cost” (the cost of abating one more ton/yr. of emissions) will increase with the total amount of abatement. 10,000 ($/ton) (tons/yr.) marginal abatement cost Note: In this graph pollution abatement (reduction) increases from left to right.

($/ton) (tons/yr.) Start with the graph again and rotate it about a vertical axis. 10, Now abatement is measured from right to left and unabated pollution is measured from left to right. 010,000

When set up in this way, the graph shows WTP for pollution rights. 3,000 For example, the utility’s WTP for the right to emit the 3,000th ton/yr. of pollution would be the cost they would save by not having to abate it.... and this is the height of the curve at a quantity of 3,000 tons/yr. ($/ton) (tons/yr.) 0 10,000 WTP for 3,000th ton/yr. 7,000 This would be the marginal cost of the 7,000 ton/yr. of abatement...

This gives us the utility’s demand curve for pollution rights. ($/ton) (tons/yr.) 010,000 Suppose the utility had to purchase the right to pollute at any given level. 6,000 The utility would demand 6,000 tons/yr. of pollution rights. It would abate 4,000 tons/yr. of its previous emissions level Price of pollution “rights” = 90 $/ton.... because these could be abated at marginal cost < 90 $/ton. It would continue to pollute 6,000 tons/yr because for these, it’s cheaper to pay for the right to pollute than to abate.

Now two utilities, each emitting 10K tons/yr. to start, but with different demands for pollution rights. Suppose the EPA wants to limit total emissions to 10K tons/yr. One (“command-and-control”) approach: ($/ton) 10,000 “Watts-are-us” 5K limit for each. ($/ton) 10,000 (tons/ yr.) “Powerama” 5,000

The problem: Two utilities would operate at different marginal abatement costs. ($/ton) 10,000 (tons/ yr.) “Powerama” ($/ton) 10,000 “Watts-are-us” Powerama could pollute 1 more (abate 1 less): savings = $120. Watts-are-us could pollute 1 less (abate 1 more): extra cost = $100. Same total emissions but lower cost. 5, ,

To get any given level of pollution abatement in the least-cost way, we have to have both (all) utilities operating at the same marginal abatement cost. One (“market-based”) approach to achieving this: Put a “price” on pollution rights by imposing a pollution tax. Let’s say that a tax of 108 $/ton is the “right” level to achieve the target of 10K tons/yr. in total emissions. (It depends on the demand curves.)

Let’s bring back the two graphs: Here’s where they were with individual limits of 5K tons/yr. Here’s where they’ll be facing a 108 $/ton pollution tax. ($/ton) 10,000 (tons/ yr.) “Powerama” 4,500 5,500 ($/ton) 10,000 “Watts-are-us” 5, ,

Both utilities pollute up the point at which the pollution tax (or “price” of pollution rights) is equal to marginal abatement costs. Result: Equal marginal abatement costs, which means that the emissions target (10K tons/yr.) is achieved with lowest total cost. This is the reason for economists’ preference for “market-based” approaches.

The utility with “low” marginal abatement costs (Watts- are-us) abates a little more (pollutes a little less) and the utility with “high” marginal abatement costs (Powerama) abates a little less (pollutes a little more). What if the EPA doesn’t know pollution rights demands, so it can’t calculate that 108 $/ton is the “right” tax for a 10K ton/yr. target? Alternative market-based approach: Tradable pollution permits.

($/ton) 10,000 (tons/ yr.) “Powerama” EPA issues permits for 5,000 tons/yr. to each utility. Powerama (“high” marginal value for permits) can buy extras from Watts-are-us (“low” marginal value for permits). ($/ton) 10,000 “Watts-are-us” 5, ,

Trade will equalize marginal value of permits (marginal abatement costs). Same result as with 108 $/ton pollution tax ,500 5,500 ($/ton) 10,000 (tons/ yr.) “Powerama” ($/ton) 10,000 “Watts-are-us”

Tradable permits are used by EPA to control acid rain. “Cap and Trade” approach. ( Clean Air Act Amendments of 1990 (first year in operation: 1995) (from New York Times, 10/24/97) “Under the Clean Air Act, total sulfur emissions are capped by giving electric utilities rights to emit sulfur in proportion to their lower, 1980 emissions. Companies that reduce emissions below their allowance by closing plants, switching fuels or attaching chemical scrubbers to their smokestacks are free to sell their surplus pollution rights, while others are free to exceed their limits by buying those rights. Last year (1996), the market price of sulfur allowances averaged just more than $100/ton.”

Some people have a problem with the pollution permit giveaway. Utilities get the permits for free, but they have a market value. (A total of about $1 billion per year.) Utilities like Watts-are-us recapture some of this value through sale of surplus permits. Is this “fair”? Utilities are subject to “rate-of-return” regulation. (Prices are set by government agency so as to limit utilities’ profits to a “fair” level.) Value of pollution permit windfall is passed to consumers in the form of lower electricity prices.

Back to sale of pollution permits (“sulfur allowances”): Most sales are privately negotiated but the EPA holds allowance auction each year. ( Bidders submit sealed bids including bid price and number of allowances. Allowances sold to highest bidder until no allowances remain. Results from the March 2010 auction: “Clearing price” (lowest bid that was successful): $ (It was $62 in 2009 and $380 in 2008.)

Some winning bidders from the 2010 sale: ( Ohio Valley Electric Corporation ( $36.88 each) Green Country Energy LLC ( $ each) Acid Rain Retirement Fund $81.36 each) ( Bates College Environmental Econ ( $42.67 and $45.50)

More Cap and Trade programs in the future? H.R American Clean Energy and Security Act of 2009 (“Waxman – Markey Climate Bill”) ( (Rep. H. Waxman (D – CA), Rep. E. Markey (D – MA)) Measures to promote clean energy + energy efficiency... including a Cap and Trade program for “greenhouse gases” responsible for global warming. Passed House in June 2009 (219 – 212). Little chance in Senate